Lecture 4 Flashcards
(5 cards)
1
Q
What is Modigliani & Miller (1958) Proposition 1?
A
- In a perfect capital market, the value of a firm (i.e debt/bonds and equity/shares) is independent of its capital structure. So: value of market Vl = value of firm Vu
- There is NO optimum capital structure to maximise firm value
- “Perfect capital market” => NO taxes, NO transaction costs and individuals can borrow/lend money at the same rate as corporations
2
Q
What is Modigliani & Miller (1958) Proposition 2?
A
- As leverage increases (more equity), the cost of equity rises because equity becomes riskier
- Debt is safer due to priority claims
- Equity has residual claim (get paid after debtholderes) with higher leverage
- Higher equity risk = higher expected return (cost of equity)
3
Q
What is M & M (1963) Proposition 1 WITH Corporate Tax?
A
- Interest is tax-deductible, but dividends aren’t, so using debt helps firms pay less tax.
- This tax saving is called the tax shield of debt.
- As a result, a leveraged firm is worth more than an all-equity firm.
4
Q
What does M & M (1963) Proposition 2 WITH Corporate Tax state?
A
- The cost of equity increases with leverage (M&M (1958) Proposition 2), but the overall cost of capital (WACC) decreases because of the tax shield of debt (interest payments are tax deductible)
5
Q
What did Miller (1977) WITH personal tax state?
A
- When you include both corporate and personal taxes, the benefit of using debt shrinks, and in some cases, disappears entirely
